Creation vs. Diversion

When an investment opportunity seems too good to be true, prudence recommends asking: “Will I be sharing in wealth that I help to create, or will I taking some wealth from its real producers?”

A chain letter is an example of just diverting wealth. So is a Ponzi scheme; so is the familiar Nigerian email scam, which gains superficial plausibility from a whiff of dishonesty or illegality.

Similarly, someone engaged in a possibly though not obviously productive business — perhaps some complicated Wall Street transaction — may well ask about creation or diversion of wealth. If not conscience, then concerns about legality and the dependability of success prompt the question.

Someone offering a suspiciously attractive opportunity might dodge the question about wealth creation by saying that the success of his method, though honorable — a method of choosing stocks and timing transactions, perhaps — depends on secrecy. Even so, an answer in general terms is in order; and the vaguer the answer, the more skepticism prudence recommends.

Beyond physical objects, wealth of course includes intangibles such as education, repair and other services, transportation, entertainment, travel and tourism, and comforts of various kinds. Similarly, the production of wealth includes not just growing or physically shaping things but also specialization, the division of labor, and exchange. (Each party to a voluntary and informed transaction gains what he considers more wealth than what he gives.)

Financial operations come into the story. Arbitrage of the most obvious kind moves resources or products from where they are less scarce and valuable to where they are scarcer and more valuable; and by ironing out price discrepancies, it makes the price system more accurate in equilibrating supply and demand. A well functioning market generates knowledge and uses it productively.

Speculation — most obviously but not only in standard commodities — is a kind of arbitrage in time, moving things from a time when they are less valuable to a time when they are more valuable. If something, say wheat, is expected to become scarcer in the future, a speculatively bid-up price tends to hasten economies in consuming the thing and possibly hasten its production, thereby lessening its future scarcity.The speculators themselves bear the costs of being wrong. Speculation contributes to the depth and resiliency of futures and forward markets, where businesses can hedge against the risk of adverse price changes (and where, as a result, opposite risks can more or less neutralize one another). Insurance is an obvious example of hedging against risk.

Saving and investment make possible the increased productivity of well-chosen roundabout, time-consuming, capital-using kinds and methods of production. (Here “capital” means resources freed by savers from serving current consumption so they can serve longer-term-oriented production instead.) The stock markets and related activities help allocate capital to places where it promises to be most productive. Financial intermediation tailors the terms on which capital is available to the varied wants and needs of savers, borrowers, and companies issuing stock; securitization of loans is just one example.

Like capital, risk-bearing is an essential element in production, especially innovative production. Various kinds of stocks and bonds and derivatives, including even the notorious credit-default swaps, help place risk with the persons and institutions most willing and able to bear it. Specialization in risk-bearing enhances confident and productive business planning.

The great variety of financial operations and innovations allows scope, notorious scope, for ignorance, error, and downright fraud. (Some participants, such as Enron energy traders, reputedly, may see their business as a struggle in which the other side is supposed to lose.) More broadly, wealth comes in so many forms, and cooperation in producing it occurs in so many ways, even very indirect ways, that an answer to the question with which I started can seldom be precise.

Nevertheless, insisting on whether wealth is being created or merely diverted can provide healthy discipline.